Economic policy advice for the NDP, Part IV: Corporate income taxes

Here is my first recommendation to the NDP on corporate income taxes: accept the fact that previous NDP positions have been - to put it kindly - painfully amateurish and should be discreetly tossed into the Dumpster of Disavowed Doctrines. It's tabula rasa time, and the long path back to reality-based policy starts below the fold.

The first thing to discuss is efficiency issues; happily, much of this material was covered when we discussed the advantages of the GST. Briefly put, higher corporate taxes reduce the after-tax rate of return on investment, and this in turn reduces investment, employment and income below what they might otherwise have been.

Of course, we might be prepared to pay this price if increasing corporate taxes reduced inequality, and there are apparently people who believe that this is in fact the case. As far as I can tell, this argument goes along the following lines:

Corporate taxes are applied on profits.

Profits go to capitalists.

Corporate taxes are paid by capitalists

Capitalist = rich person, therefore

Corporate taxes are paid by rich people

The first two statements are of course true, but everything else is wrong:

Corporate taxes are not paid by capitalists. Here we have to think about the incidence of corporate taxes. If the owners of the firm can pass the tax along in the form of higher prices, lower wages and/or reduced employment while maintaining the same after-tax rate of profit, then the burden of the corporate tax is borne entirely by workers and consumers. And if firms must compete for investment in an integrated global capital market - as is the case of firms operating in Canada - then that's exactly what will happen. Even if they're not the ones who write the cheque to the Receiver-General, the people who really pay corporate taxes are consumers (in the form of higher prices) and workers (in the form of reduced wages and employment). For more on this point, see Who pays corporate taxes? and Why progressives should support reducing corporate tax rates.

Capitalist != rich person. One thing that an increase in the corporate income tax will do is to induce a one-time fall in stock prices. If you think that this advances the progressive agenda, remind yourself of the following:

The increase in inequality at the high end of the income distribution is generated by wage income, not by the value of their capital holdings (see Lesson 1).

A reduction in stock prices hits the values of pension funds as well. An ethical framework that treats a retired school teacher as equally deserving of punishment as Scrooge McDuck is perhaps something that should be rethought.

Peter Lindert's book Growing Public makes the point that big governments do not have the luxury of indulging in sentiment in designing tax policy, because their mistakes have correspondingly large consequences. This is a lesson that has been learned by successful social democratic governments - including the one in Manitoba, which has recently realised that lower corporate tax rates are not inconsistent with progressive goals. Here are graphs of the statutory corporate income tax (CIT) rates, the effective rates and the marginal effective rates in various rich countries plotted against the levels of social spending:

Here are the effective rates (taxes as a percentage of the tax base after deductions):

And here are the CD Howe estimates for the marginal effective tax rates (the tax on an extra dollar of profits):

As can be seen in the first graph, the governments of Jean Chrétien, Paul Martin and Stephen Harper have implemented several rounds of corporate tax cuts since 2000, and future reductions have already been announced. These will bring us down to the levels of the Nordic countries, and that's probably enough for now. So my main recommendation for the NDP when it comes to corporate tax policy is to say nothing. No promises to cut taxes, no promises to rescind the ones previously announced. Saying nothing is better than saying something stupid, and that's probably the best we can hope for for now.

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As can be seen in the first graph, the governments of Jean Chrétien, Paul Martin and Stephen Harper have implemented several rounds of corporate tax cuts since 2000...

And what have those corporate tax cuts done for us? Reliance on economic theories to sell a policy is only acceptable in the absence of real data. Since we now have real data to gauge the effectiveness of corporate tax cuts I can't see how you can make this suggestion without addressing it.

How would reduced corporate taxes lead to more outsourcing? Operating in Canada would be less expensive. They would have more money that could be invested overseas, but so what? They would have more money to invest in Canada as well.

Too much fed - count me in as one of those puzzled by your linkage of outsourcing and corporate taxes. I suspect one *might* link corporate flight and corp taxes, but in a direct rather than your inverse relationship.

Is there a difference between corporate profit and corporate investment?

Here is an example. A corporation keeps its "tax headquarters" in Canada because of a corporate tax cut but still sends its investment overseas to lower its cost of production and then imports the cheaper product.

Fed: In the situation you describe (off-shoring production and trying to bring profits home), I hope you realise that the income tax reduction would not create the incentive to off-shore. That exists either way. In fact, most countries have elaborate rules in terms of how firms trade with themselves between countries in order to try to prevent profits from being shipped to the lowest tax jurisdiction. So really, low corporate taxes would tend to justify investments in the low tax jurisdiction, as benefits from investments in other jurisdictions are difficult to transfer to the low tax jursidiction.

You said:
"What if there is a cut in the corporate tax rate and the board and ceo decide to increase the dividend, increase a stock buyback, or jack up their own wages?"

To which the answer is, if they increase dividends the return on investment for equity increases, making it easier for them to raise capital and invest - Stephen's point (the same holds true for stock buybacks). Furthermore, to some extent the "lost" tax revenue at the corproate level would be offset by increased tax paid at the shareholder level on higher dividends (since dividends are subject to either personal income tax, for Canadian residents, or withholding tax, for non-residents), though that likely wouldn't entirely offset it. And CEO's or their boards jacked up their own wages, great, they're subject to tax at at 46% marginal rate (in Ontario).

The funny thing is that, in important respects, the nordic countries have much lower income tax rates than Canada does. Sweden, for example, has a very low flat tax rate of 20 odd percent (I'm going on memory here, so I stand to be corrected) on investment income (compared with top marginal tax rates on investment income in Ontario ranging from 23% to 46%, depending on the type of income - capital gains, interest, dividends, foreign dividends, etc). Since taxing investments is generally considered to be a highly inefficient form of taxation (in that it imposes high costs on society, through lost jobs and output) relative to the revenue it raises because it discourages investment (much like taxing cigarettes discourages smoking) the Swedish strategy makes a lot of sense. This sort of smart thinking on investment is probably part of the reason why the Nordic countries are such world beaters in terms of their businesses.

It's true that the Swedes have a higher marginal tax rate on labour income than we do, and it kicks in at much lower incomes (again, I stand to be corrected, but I think they have a 56% flat tax on labour income which kicks in at something like 30K a year). On the other hand, because of the high threshold before that tax kicks in, most Swedes (and particularly those at the bottom of the income spectrum) probably pay less income tax than we.

Where the Swedes, and European countries generally, really bring in the money are in valued-added taxes (like the GST) and payroll taxes, both of which are relatively efficient taxes since value added taxes are taxes on consumption (not investment) and payroll taxes are taxes on the, generally, inelastic supply of labour.

In any event, for a given level of govenment spending you have to raise the revenue somewhere. Personally, and this shouldn't be an ideological issue, I think it makes sense to raise that revenue using the most efficient taxes possible (i.e., consumption, payroll, or labour income taxes) and drop the least efficient taxes (particularly taxes on investment). If you can't get progressive results using the tax system (and, don't forget, it's entirely possible to have a progressive consumption tax), just use the taxes to collect money and get progressive results through spending.

thanks Bob for that explanation. Having spend my twenties in the working poor class, i can assure you that i would happily pay more gst taxes in order to pay less in income tax.
on a side note, perhaps this site could take some time to explain our tax system. i now work on a rig and am amazed on little people know. Some believe that by moving up in the pay scale (bottom is the roughneck, at the top is the driller), they'll actually have less income because they believe that the higher taxes they pay is paid on their whole income, not simply the income for that tax group.

It's funny what people believe about our tax system. Your experience is probably not uncommon. A lot of people get confused aboutthe difference between their average tax rate (the rate they actually pay) and their marginal tax rate (what they pay on their last dollar earned). So they tend to think that they pay more taxes than they really do. It also explains your experience with people thinking they will have less income as their pre-tax income rises, because they forget that only the extra income is taxed at the higher rate.

IF. The key word in your post is IF. IF companies can get away with passing the cost of the taxes on, they will. Whether they can depends on the elasticity of their markets. In inelastic markets, they can't raise prices without seeing their sales drop. The only way out is to cut their profits. This hurts shareholders, who are drawn more from the upper classes than the lower. Yes, some lower-income Canadians who receive pension income will be affected as well, but they will benefit disproportionately from the public services financed by the corporate taxes.

From what I understand, careful sector-by-sector analysis of corporate tax incidence shows that the effects you describe - higher prices and lower wages - are felt more on luxury goods and higher-income workers, where markets tend to be more elastic.

Also, corporate taxes have a powerful automatic stabilizer - since profits fall or even disappear during recessions, this automatically adjusts taxes as well.

Most tax cutters argue that if you want more of something, tax it at a lower rate. If you want less of something, tax it at a higher rate.

If corporate taxes are cut, you will get more corporate income (and maybe its incentive). It seems to me that corporations use cheap labor to attempt to increase corporate income. So why wouldn't cutting corporate taxes increase corporate income (and maybe its incentive), and therefore increase the usage of (investment in) cheap labor?

Andrew F said: "Fed: In the situation you describe (off-shoring production and trying to bring profits home), I hope you realise that the income tax reduction would not create the incentive to off-shore."

Andrew F said: "In fact, most countries have elaborate rules in terms of how firms trade with themselves between countries in order to try to prevent profits from being shipped to the lowest tax jurisdiction."

Not a fan of democrats or republicans. Not sure how it works in Canada but in the USA and from:

http://www.bloomberg.com/apps/news?pid=20601087&sid=a4.7CIfqd5h0

"Obama Seeks End of Corporate Tax Break to Raise $190 Billion"

"In 2004, U.S.-based multinational corporations paid about $16 billion in U.S. taxes while earning about $700 billion offshore, an effective tax rate of about 2.3 percent, according to the administration statement. The top marginal tax rate for U.S. companies is 35 percent; drug companies such as Amgen Inc. and technology companies such as Microsoft are among companies that make the biggest use of tax-deferral benefits.

The rules were originally designed to reduce paperwork for companies and the IRS by allowing companies to classify entities within their corporate structure in the most tax-efficient manner without inviting a tax challenge.

Unintended Consequence

Clinton administration officials realized they also had made it easy for multinationals to create entities whose only purpose was to shift profits into low-tax countries and out of reach of the tax authorities, according to a January Government Accountability Office report that found 83 of the 100 biggest companies had subsidiaries in tax havens.

Once the assets were in the haven, the U.S. parent company borrowed from the subsidiary. The interest payments were deductible in the U.S. and tax-free in the haven, the GAO said. The nonpartisan congressional Joint Committee on Taxation recommended in 2005 that the rules be repealed."

You said:
"What if there is a cut in the corporate tax rate and the board and ceo decide to increase the dividend, increase a stock buyback, or jack up their own wages?"

To which the answer is, if they increase dividends the return on investment for equity increases, making it easier for them to raise capital and invest - Stephen's point (the same holds true for stock buybacks)."

What if a company can fund investment from cash flow?

What if not investing (withholding supply) raises return on investment by keeping prices high? Think OPEC leaving oil in the ground.

What if there are excess corporate profits that the company can't find a good way to reinvest because of a lack of aggregate demand?

Corporations have the incentive to use cheap(er) labour with or without income taxes. Why would income taxes make a firm want to only hire well-paid employees? Of course, this is true of any input, not just labour. Seems to me that a reduction in income tax wouldn't make a firm necessarily replace its existing employees with cheaper labour, but it might give it the incentive to augment its existing investments with ones using cheaper labour.

I guess that's what I meant when I said the incentive to get value for money (use cheaper labour) exists regardless of the level of income tax on corporations.

I'll agree with you that US tax law is insane. That's because firms have politicians bought and paid for, and buy their exemptions from law. Of course, being able to shelter their US income from tax means that the tax doesn't reduce investment returns on investments in the US (but investments in other countries are taxed at that jurisdiction's rate).

"What if a company can fund investment from cash flow?"

Irrelevant. A firm's shareholders will be displeased if rather than giving dividends, they make investments that yield a return substantially below what they could get elsewhere. Usually, if firms can't get payback in the four to five year range, they don't make such investments.

Again, not relevant. This is an issue of monopoly power, and is a problem with or without income tax. If it is a flat tax on income, firms should not change behaviour at all (using my rusty microeconomics education).

"What if there are excess corporate profits that the company can't find a good way to reinvest because of a lack of aggregate demand?"

Pay dividends to shareholders, who can then invest it elswhere (where there is a high enough return on offer). This is mostly irrelevant, too. Mature firms do this all the time. In the long run, the entire point of a corporation is to pay dividends to shareholders.